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Sears Looks Like the Next Company With Head-Scratching CDS Trade

(Bloomberg) -- For the past two years, credit-derivatives traders have been betting almost certain odds that Sears Holdings Corp. will default on its debt. Now, those wagers are being turned upside down by a complex proposal from the retailer’s biggest shareholder.

Eddie Lampert’s ESL Investment Inc., the hedge fund that owns the most Sears shares, last month urged the retailer to sell some of its businesses, and said it would look to buy them. As part of its proposal, the fund said that Sears should buy back what had been some of its lowest-priced debt.

Traders are now betting that the suggestion is an example of a creative financing transaction, where fund managers lend to companies under terms designed to create big profit for the funds’ side bets in credit derivatives, according to market participants with knowledge of the matter. Such financings have grown more popular over the last year, with newspaper publisher McClatchy Corp. and homebuilder Hovnanian Enterprises Inc. having agreed to them.

Creative financing transactions are drawing complaints from critics who say they amount to manipulation of the $11 trillion credit derivatives market. The Commodity Futures Trading Commission said it is looking at the practices.

In the case of Sears, traders are wagering that ESL will follow through on its proposal, and the department store will buy back or swap what had been its cheapest debt. A company’s lowest-priced debt is typically used to determine payouts on credit derivatives, so retiring the borrowings could translate to bigger profits for hedge funds that bet on a Sears unit staying solvent for the next year by selling default insurance contracts. Representatives for ESL and Hoffman Estates, Illinois-based Sears and declined to comment.

Speculation that such a deal is in the works has pushed down the cost of protecting Sears debt against default for a year in the credit derivatives market to levels not seen since October 2016, data compiled by Bloomberg and price provider CMA show. The price started falling in late April, after ESL announced its proposal.

Selling Assets

The declines have come even as money managers may have more reason to be concerned about the retailer’s ability to pay its obligations. Sears said last week that it was formally starting a process to sell its Kenmore appliance brand and parts of its home-services business after reviewing ESL’s proposal. To some analysts, that announcement smacked of desperation. The retailer hired advisers to explore selling those units two years ago.

The announcement that Sears is selling the businesses now is probably an indication that the company has a cash crunch that is so severe it needs to raise money now to stay open and finance its Christmas inventory, wrote Bill Dreher, an analyst at institutional brokerage Susquehanna Financial Group, in a note last week.

Many of what had been Sears’ cheapest bonds bonds are now surging. Some $43 million of 7.5 coupon bonds due in 2027 have rocketed more than 36 cents on the dollar since April, to around 74 cents on the dollar, a level not seen since 2015.

The Sears transaction has some parallels with McClatchy’s. The ailing newspaper chain said last month that one of its subsidiaries was borrowing to refinance most of the parent company’s debt. That shift could result in profit for traders who sold credit derivatives amounting to insurance against the parent defaulting. Those traders will essentially have little debt to guarantee, allowing them to just collect premium. Chatham Asset Management, McClatchy’s biggest shareholder, lent money to the publisher’s subsidiary and sold credit derivatives on the parent company.

Under ESL’s plan for the Sears assets, the retailer would sell assets to the hedge fund and use the proceeds to buy back long-dated unsecured bonds at its Sears Roebuck Acceptance Corp. unit. Sears would also exchange half of the unit’s second-lien debt not secured by real estate for equity in Sears.

Those bonds have been the lowest-priced of the unit’s debt. A buyer of credit derivatives profits from the difference between the face value of a company’s debt and its cheapest bonds, so eliminating low-priced debt decreases the potential payouts for the buyer and gives a higher return to the seller.